UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended June 30, 2011

 

Commission File No. 1-31753

 

CapitalSource Inc.

(Exact name of registrant as specified in its charter)

 

 

5404 Wisconsin Avenue, 2nd Floor

Chevy Chase, MD 20815

(Address of Principal Executive Offices, Including Zip Code)

 

(301) 841-2700

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of July 28, 2011, the number of shares of the registrant’s Common Stock, par value $0.01 per share, outstanding was 322,795,880.

 

 

TABLE OF CONTENTS

 

CapitalSource Inc.

 

Consolidated Balance Sheets

 

 

See accompanying notes.

CapitalSource Inc.

 

Consolidated Statements of Operations

 

 

See accompanying notes.

CapitalSource Inc.

 

Consolidated Statement of Shareholders’ Equity

 

 

See accompanying notes.

CapitalSource Inc.

 

Consolidated Statements of Cash Flows

 

 

See accompanying notes.

 

 

References to we, us, the Company or CapitalSource refer to CapitalSource Inc., a Delaware corporation, together with its subsidiaries. References to CapitalSource Bank include its subsidiaries, and references to Parent Company refer to CapitalSource Inc. and its subsidiaries other than CapitalSource Bank. We are a commercial lender that, primarily through our wholly owned subsidiary, CapitalSource Bank, provides financial products to small and middle market businesses nationwide and provides depository products and services in southern and central California.

 

For the three and six months ended June 30, 2011, we operated as two reportable segments: 1) CapitalSource Bank and 2) Other Commercial Finance. For the three and six months ended June 30, 2010, we operated as three reportable segments: 1) CapitalSource Bank, 2) Other Commercial Finance, and 3) Healthcare Net Lease. Our CapitalSource Bank segment comprises our commercial lending and banking business activities, and our Other Commercial Finance segment comprises our loan portfolio and other business activities in the Parent Company. Our Healthcare Net Lease segment comprised our direct real estate investment business activities, which we exited completely with the sale of all of the assets related to this segment during 2010, and consequently, we have presented the financial condition and results of operations within our Healthcare Net Lease segment as discontinued operations for all periods presented. We have reclassified all comparative period results to reflect our two current reportable segments. For additional information, see Note 19, Segment Data.

 

 

Interim Consolidated Financial Statements Basis of Presentation

 

Our interim consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, certain disclosures accompanying annual consolidated financial statements prepared in accordance with GAAP are omitted. In the opinion of management, all adjustments and eliminations, consisting solely of normal recurring accruals, considered necessary for the fair presentation of financial statements for the interim periods, have been included. The current period’s results of operations are not necessarily indicative of the results that ultimately may be achieved for the year. The interim consolidated financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2010, as filed with the Securities and Exchange Commission on February 28, 2011 (“Form 10-K”).

 

The accompanying financial statements reflect our consolidated accounts and those of other entities in which we have a controlling financial interest including our majority-owned subsidiaries and variable interest entities (“VIEs”) for which we determined that we are the primary beneficiary. All significant intercompany accounts and transactions have been eliminated.

 

Reclassifications

 

Certain amounts in prior period consolidated financial statements have been reclassified to conform to the current period presentation, including the reclassification of fee income to interest income or other income, net and the reclassification of letter of credit fee expense from interest expense to other income, net in our audited consolidated statements of operations. Accordingly, the reclassifications have been appropriately reflected throughout our consolidated financial statements.

 

Except as discussed below, our accounting policies are described in Note 2, Summary of Significant Accounting Policies, of our audited consolidated financial statements as of December 31, 2010, included in our Form 10-K.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

New Accounting Pronouncements

 

In January 2010, the Financial Accounting Standards Board (“FASB”) amended its guidance on fair value measurements and disclosure, which was intended to improve transparency in financial reporting by requiring enhanced disclosures related to fair value measurements. These new disclosures provided for disclosure of transfers between Level 1 and Level 2 of the fair value hierarchy, of fair value measurements for each class of assets and liabilities presented, of separate information for acquisitions, sales, issuances, and settlements in the rollforward of activity of Level 3 fair value measurements, and of valuation techniques used in recurring and nonrecurring fair value measurements for both Level 2 and Level 3 measurements. We adopted this guidance on January 1, 2010, except for the guidance related to acquisitions, sales, issuances, and settlements in the rollforward of activity of Level 3 fair value measurements, which is effective for annual reporting periods ending after December 15, 2010, and for interim periods within those annual reporting periods. We adopted the guidance related to the rollforward of activity of Level 3 fair value measurements on January 1, 2011, and it did not have a material impact on our consolidated financial statements.

 

In July 2010, the FASB amended its guidance on financing receivables to improve the disclosures that an entity provides about the credit quality of its financing receivables and the related allowance for credit losses. As a result of these amendments, an entity is required to disaggregate by portfolio segment and class certain existing disclosures and provide certain new disclosures about its financing receivables and related allowance for credit losses. This guidance was effective for interim and annual periods ending on or after December 15, 2010 for disclosures as of the end of a period and for interim and annual periods beginning after December 15, 2010 for disclosures related to activity during a period. We adopted the guidance for disclosures as of the end of a period on October 1, 2010 and for disclosures related to activity during a period on January 1, 2011. For further information, see Note 5, Loans and Credit Quality.

 

In April 2011, the FASB amended its guidance on loans to clarify which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings. In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. This guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption. We adopted this guidance as of July 1, 2011, and we anticipate that the adoption will not have a material impact on our consolidated financial statements.

 

In May 2011, the FASB amended its guidance on fair value measurements to achieve common disclosure requirements for GAAP and International Financial Accounting Standards (“IFRS”). The amendments clarify existing GAAP requirements for fair value measurements and eliminate wording differences between current GAAP and IFRS guidelines. This guidance is effective for interim and annual periods beginning after December 15, 2011. We plan to adopt this guidance as of January 1, 2012, and we anticipate that the adoption will not have a material impact on our consolidated financial statements.

 

In June 2011, the FASB amended its guidance on the presentation of comprehensive income. This guidance eliminates the option to report other comprehensive income and its components in the consolidated statement of shareholders’ equity. An entity may elect to present items of net income and other comprehensive income in one continuous statement, referred to as the statement of comprehensive income, or in two separate, but consecutive, statements. Each component of net income and of other comprehensive income needs to be displayed under either alternative. This guidance is effective for interim and annual periods beginning after December 15, 2011. We plan to adopt this guidance as of January 1, 2012, and we anticipate that the adoption will not have a material impact on our consolidated financial statements.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

In 2010, we completed the sale of our long-term healthcare facilities, and as a result, we exited the skilled nursing home ownership business. Consequently, we have presented the results of operations for this business as discontinued operations for all periods presented. Additionally, the results of the discontinued operations include the activities of other healthcare facilities that have been sold since the inception of the business.

 

The condensed statements of operations for the three and six months ended June 30, 2011 and 2010 for our discontinued operations were as follows:

 

 

 

As of June 30, 2011 and December 31, 2010, our cash and cash equivalents and restricted cash balances were as follows:

 

 

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

As of June 30, 2011 and December 31, 2010, our outstanding loan balance was $5.6 billion and $6.4 billion, respectively. Included in these amounts were loans held for sale and loans held for investment. As of June 30, 2011 and December 31, 2010, interest and fee receivables totaled $33.6 million and $52.7 million, respectively.

 

Loans Held for Sale

 

We determine when to sell a loan on a loan-by-loan basis and consider several factors, including the credit quality of the loan, any financing secured by the loan and any requirements related to the release of liens and use of sales proceeds, the potential sale price relative to our loan valuation, our liquidity needs, and the resources necessary to ensure an adequate recovery if we continued to hold the loan. When our analysis indicates that the proper strategy is to sell a loan, we initiate the sale process and designate the loan as held for sale.

 

During the three months ended June 30, 2011 and 2010, we transferred to held for sale, from held for investment, loans with a carrying value of $135.4 million, all of which were impaired, and $55.2 million, of which $41.7 million were impaired, respectively. These transfers were based on our decision to sell these loans as part of overall portfolio management and workout strategies. We incurred $1.4 million and $7.5 million of losses due to valuation adjustments at the time of transfer during the three months ended June 30, 2011 and 2010, respectively. We did not reclassify any loans from held for sale to held for investment during the three months ended June 30, 2011 and 2010, respectively.

 

During the six months ended June 30, 2011 and 2010, we transferred to held for sale, from held for investment, loans with a carrying value of $165.7 million, all of which were impaired, and $92.8 million, of which $70.7 million were impaired, respectively. We incurred $1.4 million and $7.5 million of losses due to valuation adjustments at the time of transfer for the six months ended June 30, 2011 and 2010, respectively. We reclassified $28.6 million and $10.5 million of loans from held for sale to held for investment during the six months ended June 30, 2011 and 2010, respectively, based upon our intent to retain these loans for investment.

 

During the three and six months ended June 30, 2011, we recognized net pre-tax gains of $3.1 million and $4.4 million, respectively, related to sales of loans. During the three and six months ended June 30, 2010, we recognized net pre-tax losses of $7.6 million and $7.5 million, respectively, related to sales of loans.

 

As of June 30, 2011 and December 31, 2010, loans held for sale with an outstanding balance of $118.7 million and $14.7 million, respectively, were classified as non-accrual loans. We did not record any fair value write-downs on non-accrual loans held for sale during the three and six months ended June 30, 2011. We recorded $5.6 million in fair value write-downs on non-accrual loans held for sale during the three and six months ended June 30, 2010.

 

Loans Held for Investment

 

Loans held for investment are recorded at the principal amount outstanding, net of deferred loan costs or fees and any discounts received or premiums paid on purchased loans. We maintain an allowance for loan and lease losses for loans held for investment, which is calculated based on management’s estimate of incurred loan losses inherent in our loan portfolio as of the balance sheet date. This methodology is used consistently to develop our allowance for loan losses for all loans in our loan portfolio, and, as such, we maintain a single portfolio segment. The loans in our portfolio are grouped into seven loan classes, based on the level that we use to assess and monitor the risk and performance of the portfolio, including the nature of the borrower, collateral and lending arrangement.

 

Non-performing loans are loans accounted for on a non-accrual basis, accruing loans which are contractually past due 90 days or more as to principal or interest payments and other loans identified as troubled debt restructurings (“TDRs”) as defined by GAAP.

 

During the three and six months ended June 30, 2011, we purchased loans held for investment with an unpaid principal balance of $32.0 million and $347.3 million, respectively. As of June 30, 2011 and December 31, 2010, the

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

carrying value of each class of loans held for investment, separated by performing and non-performing categories, was as follows:

 

 

 

 

As of June 30, 2011 and December 31, 2010, CapitalSource Bank pledged loans held for investment with an unpaid principal balance of $367.2 million and $166.1 million, respectively, to the Federal Home Loan Bank of San Francisco (“FHLB SF”) as collateral for its financing facility.

 

Credit risk within our loan portfolio is the risk of loss arising from adverse changes in a client’s or counterparty’s ability to meet its financial obligations under agreed-upon terms. The degree of credit risk will vary based on many factors including the size of the asset or transaction, the credit characteristics of the client, the contractual terms of the agreement and the availability and quality of collateral.

 

We use a variety of tools to continuously monitor a client’s ability to perform under its obligations. Additionally, we syndicate loan exposure to other lenders, sell loans and use other risk mitigation techniques to manage the size and risk profile of our loan portfolio.

 

Credit risk management for the loan portfolio begins with an assessment of the credit risk profile of a client generally based on an analysis of the client’s payment performance, cash flow and financial position. As part of the overall credit risk assessment of a client, each credit exposure is assigned an internal risk rating that is subject to approval based on defined credit approval standards. While rating criteria vary by product, each loan rating focuses on the same two factors: financial performance and collateral. Subsequent to loan origination, risk ratings are monitored on an ongoing basis. If necessary, risk ratings are adjusted to reflect changes in the client’s financial condition, cash flow or financial position. We use risk rating aggregations to measure and evaluate concentrations within the loan portfolio. In making decisions regarding credit, we consider risk rating, collateral and industry concentration limits.

 

We believe that the likelihood of not being paid according to the contractual terms of a loan is, in large part, dependent upon the assessed level of risk associated with the loan. The internal rating that is assigned to a loan provides a view as to the relative risk of each loan. We employ an internal risk rating scale to establish a view of the credit quality of each loan. This scale is based on the credit classifications of assets as prescribed by government regulations and industry standards and is separated into the following groups:

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

 

As of June 30, 2011 and December 31, 2010, the carrying value of each class of loans held for investment, by internal risk rating, was as follows:

 

 

 

 

Non-Accrual and Past Due Loans

 

We will place a loan on non-accrual status if there is substantial doubt about the borrower’s ability to service its debt and other obligations or if the loan is 90 or more days past due and is not well-secured and in the process of collection. When a loan is placed on non-accrual status, accrued and unpaid interest is reversed and the recognition of interest and fee income on that loan will stop until factors no longer indicate collection is doubtful and the loan has been brought current. Payments received on non-accrual loans are generally first applied to principal. A loan may be returned to accrual status when its interest or principal is current, repayment of the remaining contractual principal and interest is expected or when the loan otherwise becomes well-secured and is in the process of collection. Cash payments received from the borrower and applied to the principal balance of the loan while the loan was on non-accrual status are not reversed if a loan is returned to accrual status.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

As of June 30, 2011 and December 31, 2010, the carrying value of non-accrual loans was as follows:

 

 

 

 

As of June 30, 2011 and December 31, 2010, the delinquency status of loans in our loan portfolio was as follows:

 

 

 

 

Impaired Loans

 

We consider a loan to be impaired when, based on current information, we determine that it is probable that we will be unable to collect all amounts due in accordance with the contractual terms of the original loan agreement. In this regard, impaired loans include loans where we expect to encounter a significant delay in the collection of and/or a shortfall in the amount of contractual payments due to us.

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Assessing the likelihood that a loan will not be paid according to its contractual terms involves the consideration of all relevant facts and circumstances and requires a significant amount of judgment. For such purposes, factors that are considered include:

 

 

In assessing the adequacy of available evidence, we consider whether the receipt of payments is dependent on the fiscal health of the borrower or the sale, refinancing or foreclosure of the loan.

 

We continue to recognize interest income on loans that have been identified as impaired but that have not been placed on non-accrual status.

 

As of June 30, 2011 and December 31, 2010, information pertaining to our impaired loans was as follows:

 

 

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

Average balances and interest income recognized on impaired loans by loan class for the three and six months ended June 30, 2011 and 2010 were as follows:

 

 

 

 

As of June 30, 2011 and December 31, 2010, the carrying value of impaired loans with no related allowance recorded was $329.2 million and $588.7 million, respectively. Of these amounts, $143.2 million and $222.4 million, respectively, related to loans that were charged off to their carrying values. These charge offs were primarily the result of collateral dependent loans for which ultimate collection depends solely on the sale of the collateral. The remaining $186.0 million and $366.3 million related to loans that had no recorded charge offs or specific reserves as of June 30, 2011 and December 31, 2010, respectively, based on our estimates that we ultimately will collect all principal amounts due.

 

If our non-accrual loans had performed in accordance with their original terms, interest income would have been increased by $28.7 million and $61.7 million for the three and six months ended June 30, 2011, respectively, and $39.9 million and $79.4 million for the three and six months ended June 30, 2010, respectively.

 

Allowance for Loan Losses

 

Our allowance for loan losses represents management’s estimate of incurred loan losses inherent in our loan and lease portfolio as of the balance sheet date. The estimation of the allowance for loan losses is based on a variety of factors, including past loan loss experience, the current credit profile and financial position of our borrowers, adverse situations that have occurred that may affect the borrowers’ ability to repay, the estimated value of underlying collateral and general economic conditions. Provisions for loan losses are recognized when available

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

information indicates that it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated.

 

We perform quarterly and systematic detailed reviews of our loan portfolio to identify credit risks and to assess the overall collectability of the portfolio. The allowance on certain pools of loans with similar characteristics is estimated using reserve factors that are reflective of historical loss rates.

 

Our portfolio is reviewed regularly, and, on a periodic basis, individual loans are reviewed and assigned a risk rating. Loans subject to individual reviews are analyzed and segregated by risk according to our internal risk rating scale. These risk ratings, in conjunction with an analysis of historical loss experience, current economic conditions, industry performance trends, and any other pertinent information, including individual valuations on impaired loans, are factored in the estimation of the allowance for loan losses. The historical loss experience is updated quarterly to incorporate the most recent data reflective of the current economic environment.

 

If the recorded investment in an impaired loan exceeds the present value of payments expected to be received, the fair value of the collateral and/or the loan’s observable market price, a specific allowance is established as a component of the allowance for loan losses.

 

When available information confirms that specific loans or portions thereof are uncollectible, these amounts are charged off against the allowance for loan losses. To the extent we later collect amounts previously charged off, we will recognize a recovery through the allowance for loan losses for the amount received.

 

We also consider whether losses may have been incurred in connection with unfunded commitments to lend. In making this assessment, we exclude from consideration those commitments for which funding is subject to our approval based on the adequacy of underlying collateral that is required to be presented by a borrower or other terms and conditions. Reserves for losses related to unfunded commitments are included within other liabilities on our audited consolidated balance sheets.

 

Activity in the allowance for loan losses related to our loans held for investment for the three and six months ended June 30, 2011 and 2010, respectively, was as follows:

 

NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

 

As of June 30, 2011 and December 31, 2010, the balances of the allowance for loan losses and the carrying value of loans held for investment disaggregated by impairment methodology were as follows: